Two Narratives

“Creating a relatable narrative means digging deep, asking hard questions and potentially airing some uncomfortable truths.” ― Tobin Trevarthen

To understate the obvious, we are in confusing times. One day, we are elated that a vaccine might be approved and distributed. Another day, we rue the escalating caseload and impending new lockdowns.  The global investment markets are reacting to both scenarios, depending on the day’s headlines. We live in a constant flux between two narratives.

The first narrative is optimistic, about a return to normalcy with an effective vaccine(s) and widespread distribution. After mass vaccination, herd immunity should allow for increased mobility, like in the good old days of 2019. People get back to work and consumption resumes. People no longer worry about their proximity to others. Large cities become attractive once again to employers, workers, and tourists. And, with this increased economic activity, a more normal monetary and fiscal environment comes into view.

The second narrative is one of continued disruption. Not only have so many lives been lost, but the economic toll also continues to increase. Unemployment stays high and becomes structural, as industries right-size their workforce and growth plans. People increasingly drain their savings. There is ongoing and increasing demand for government fiscal stimulus and central banks walking a fine line between supporting markets and constraining adverse risk behavior (a tightrope that even Houdini would not have attempted). 

These are crude descriptions of two opposing narratives, but they serve us for the purpose of discussion.  The uncertainty and increased volatility of the investment markets are the outcome of the tug of war between these two narratives. Investors tend to have firm beliefs on what the optimal investment positioning would be for each outcome. That’s not the hard part. The issue lies, rather, in knowing which narrative is more likely, and when we might transition to it. 

If we have a continued, pandemically-induced slowdown, growth will remain scarce, with only a few technology and healthcare companies benefiting. Monetary and fiscal stimuli will continue, keeping interest rates artificially low and indebtedness high. Inertia will take over, dampening investors’ enthusiasm for funding at-risk businesses on the strength of some nebulous future recovery. The search for secular growth will become harder, just as it did after the technology bubble of 2000 burst, resulting in a multi-year decay.

Could a vaccine bring us back to normal? An economic recovery would dramatically change the leadership of the stock market, or at least that is the expectation. Those companies that are most sensitive to economic cycles have been hardest hit in both their operations and in their valuation as the world experienced the worst decline in economic activity since at least 1961. Once the weight of the pandemic is lifted, investors will gravitate to those economically sensitive firms as they benefit from an economic recovery. The nine-year run of growth companies beating value companies will stop, and value companies (those most influenced by economic activity) will thrive.

Investors appear to have defined two portfolios, one for what we are calling the Normalcy Narrative, and one for the Lockdown Narrative. Of course, massive economic destruction has occurred, and the impact of measures taken to offset the destruction may be long-lasting. Being prepared to invest wisely for either narrative is important, but we think any investment scheme for either narrative has to reckon with the economic destruction wrought by the pandemic.

World GDP is expected to shrink by 4.4% in 2020. To put that into context, consider that world GDP shrank by less than 2% in 2009. The developed economies have been hit harder, shrinking by 6%. And yet, to many, shrinkingmerely 6% is a big win when you consider the magnitude of the global shutdown and what could have happened. That “win” wasn’t without large increases in debt that will need to be paid for in the future.

As we described in our last commentary, across the globe the response to the rapidly spreading virus was an almost complete shutdown—a blunt tool used on a finely textured economy. This brutal and abrupt cessation of so much industrial and consumer activity required, in many countries, extraordinary and massive fiscal and monetary stimulus accommodations. As shown in the chart above, stimulus responses ranged from pumping into its economy the equivalent of 15% of GDP in Australia to almost 40% in Germany. We mentioned in our last commentary our distaste for the word “unprecedented,” so we will just say “wow.” And such stimuli are not, in fact, unprecedented. We have seen government-based stimuli like this in the past. Unfortunately, they did not result in good political or economic outcomes.

It is not only governments borrowing from the future to maintain the present; private institutions and individuals have been using low current interest rates to make up for the economic destruction incurred from global lockdowns. Deutsche Bank has calculated the change in debt relative to the size of an individual country’s GDP over just the last nine months: Canada has almost doubled its debt. Japan and the U.S. are doing their best to keep up.  Government-backed debt (through stimulus action) make up about half of the debt load, but the private sector has also extended its indebtedness.

As one example of the consequences, we look to the number of firms unable to service their debt, via normal operating activities, let alone pay it off. Our past commentary, we referred to that cohort as zombies and highlighted the growing number of them. The number of such zombie firms was growing prior to Covid. With the pandemic, it has certainly grown. And while the sheer number of zombie companies is telling, the level of debt they carry is another metric worth following. According to Bloomberg, almost $1.5 trillion in debt obligations is attributable to companies that cannot currently pay the interest on that debt given their operating situation. This is three times the level of such debt seen during the Great Financial Crisis. And remember, one person’s debt is another person’s savings. Not a comforting thought.

Many are asking: Why would market participants continue to provide funds to firms when the economic climate is uncertain and the ability of those firms to pay back debt is not guaranteed and likely highly in doubt? We have the same question, and we have heard no good answers, other than that the Federal Reserve and other central banks continue to push rates so low that investors—savers—are forced to reach for anything with yield. These savers are more worried about the return on their capital than the return of their capital. Some think the government will bail out firms and the risk of capital not being returned is low. We do not share that opinion.

And neither do bankers, it appears. The growing uncertainty and the unclear path to recovery, plus the high levels of indebtedness, are causing bankers to become more conservative, which does not bode well for the Normalcy Narrative. 

Lending standards are still tightening, which has traditionally resulted in lower quality companies paying higher rates for debt. The Federal Reserve’s actions during the pandemic are distorting that cause and effect.  Something must give. We believe that the fundamentals of a company more reliably determine its ability to pay back its loans than the altruistic intentions of the Fed. The central bankers certainly wield a large weapon in the face of poor market liquidity, but history has shown that using it does not offset insolvency. 

A Sharpe Perspective to Investing

At Auour, we strive to approximately track the global markets in good times and to defend against their worst impacts in bad times. Outside of overall investment returns, we look to limit our experienced losses to half that of the market and to optimize our Sharpe Ratio. The Sharpe Ratio, named after William Sharpe, one of the fathers of modern portfolio theory, is a measure of the amount of return one can achieve for a given amount of risk being taken. Think of it as similar to a fuel efficiency measure. The more miles you can drive on a gallon of gas, the better. In investing, the more return we can provide at a lower level of risk, the better.

When discussing risk, most experts are mainly discussing volatility—the degree of fluctuation in value of a portfolio that one experiences over a period of time. At the present time, volatility is high. Uncertainty remains high as investors struggle with the two narratives—and everything in between. Over the past 14 months, we have maintained a high level of cash, expecting a period of high volatility with little overall return. We are keeping our powder dry, maintaining a defensive posture, and hoping for the best but expecting the worst. However you want to describe our current positioning, it is one of holding our investor’s assets dear and stewarding them through a period of fragility (we won’t say an unprecedented period) not seen in quite some time.